Industry primers
The process of analyzing a business differs significantly from industry to industry. Many industries have their own vocabulary and specific concerns that investors should consider. This series of articles looks at specific industries and industry-specific factors that influence investment. Its goals are to highlight specific risks, clarify confusing terminology, and explain industry-specific valuation metrics. These methods complement the usual evaluation process, they do not replace it.

The oil and gas industry

Like it or not, the oil and gas sector is a central part of the global economy, powering most of the machinery and power plants on Earth. It makes sense that investors would want some exposure to the industry turning on the lights.

Global energy consumption by fuel in 2020

Source: BP Statistical Review of World Energy 2021

Industry structure

The oil and gas industry is commonly divided into 4 parts:

Upstream: The segment directly involved in the drilling and extraction of oil or gas.

The upstream sector is characterized by high volatility. Production costs are relatively constant, but product value fluctuates widely with little to no pricing power. The sector is capital intensive and known for its boom and bust cycles.

Midstream: This segment transports raw or refined material from point A to point B. Midstream often involves pipeline companies, but it can also include trains and tankers.

The midstream sector uses assets with a very long life: a pipeline can remain operational for 30-60 years if properly maintained. Investors in this segment will want to focus on buying at a discount as earnings are more stable and predictable. Growth is minimal and returns will mainly come from dividends.

Downstream: This segment converts the raw fossil fuels into useful products and distributes them to the end users. This includes refineries that convert crude oil into fuel, as well as facilities for gas liquefaction or the petrochemical industry that produces plastics, fertilizers and other chemicals.

The downstream sector has low margins and is highly capital intensive. This sector is most relevant to investors when it is vertically integrated into a company that also has upstream and midstream operations

Services: The O&G sector is a highly technical sector. There are many specialized companies that provide expertise and tools to the industry. This can be oil rigs, geological surveys, pipes, valves, pumps, sand, chemicals and much more

The O&G upstream sector

International Majors: Large vertically integrated companies operating around the world.

National Giants: Large corporations with a monopoly on one country’s resources. Often associated with high state ownership and higher political risk with less emphasis on minority shareholder rights.

Small Producers and Juniors: Usually focused on one region only. Juniors are very speculative as many are not yet producing and consuming capital to find new deposits.

Measuring oil and gas

Oil is usually measured in barrels of oil (bbl) and production in barrels per day (bpd) or million barrels per day (mmbpd). Many deposits contain both oil and gas at the same time. Reserves are then expressed in barrels of oil equivalent (boo), with the gas portion calculated “as if it were oil” to make it more understandable. Many other units are sometimes used, most notably cubic feet or cubic meters of gas, metric tons of oil, gallons, or BTU (British thermal units).

Assessing O&G investments

Production Costs/Breakeven

Each O&S depot has a specific geological profile that determines the operating costs. While this can fluctuate somewhat depending on management skills and technology, breakeven costs are somewhat stable due to the immutable geology. To be commercially viable, the break-even cost of an O&G depot must be at least 30-50% lower than the market price for oil or gas.

The lowest break-even costs provide a greater margin of safety, as other producers with higher costs will be forced to stop production first in the event of a downturn. This was the case, for example, for Canadian oil sands in the late 2010s that were unable to continue producing as oil prices fell. Low breakeven costs also allow a producer to maintain positive cash flow when the industry as a whole loses money.


Reserves are an important metric for upstream companies. Each O&G deposit has a limited lifespan determined by the resources available in the ground. An oil field producing 100,000 barrels a year with 1.5 million barrels of reserves will be exhausted in 15 years. This means that the company’s current valuation must cover much more than the value of the resources in the ground to make a profit.

To use the example above, let’s imagine the 1.5 million barrels break the cost of $40. With an expected average of $80/barrel over the next 15 years, this means 1,500,000 x $40 = $60 million in expected profit.

Given the variability of future oil prices and possible inflation in production costs, a solid margin of safety can only be achieved if the company owning this oil field is valued at less than $20 million – $30 million.

CAPEX, cash flow and depreciation

The oil and gas industry requires heavy and expensive infrastructure and equipment to function. This makes analyzing O&G finances difficult.

CAPEX is necessary and will always consume a large portion of the generated cash flow. The same goes for exploration budgets to find new deposits.

The value of the O&G deposits themselves is an asset on the balance sheet. Together with the associated infrastructure, they can be written off in the event of prolonged low prices, leading to large “paper losses” in earnings, but not in cash or cash flow.

For all of the above reasons, the preferred measure to value O&G companies should be free cash flow, rather than profit, as it better reflects the cost of CAPEX and ignores “paper losses.” It is also important to check that exploration budgets are counted as part of the total CAPEX. Without new exploration, the company will run out of resources at some point in the future.


Launching new O&S operations takes anywhere from 5-10 years, sometimes even longer in high regulatory pressure jurisdictions or for highly technical projects such as ultra-deep water drilling or arctic deposits. This is the time it takes to find the oil, get permits, find suppliers, put out tenders, build the infrastructure, rent it, ramp up production, etc.

As a result, new projects are usually only approved when market conditions appear favorable for future profitability and cash flows are high enough to fund them. So the industry usually has periods of drastically low investment in CAPEX followed by a wave of large projects. The result is regularly unbalanced production, either too little (after a long period of low CAPEX) or too much (when all new projects come online at the same time). This leads to ongoing boom and bust cycles in O&G prices.

Investors in O&G should be aware of this risk. Record cash flows and profits are often a sign of an incoming market top. Alternatively, buying after years of low prices is often very rewarding, even if current cash flows are not that great.


Due to the capital-intensive nature of the industry, many O&G companies tend to build up a lot of debt when starting new projects. This could lead to catastrophic failures and bankruptcies if the oil price continues to fall. A high-quality balance sheet is a good way to reduce risk when investing in the industry.


The cyclical nature of the sector is an investment problem. Bad management tends to waste profits from good times on growth in the worst part of the cycle. This ends in companies with unprofitable assets and high debt and ends in dramatic dilution of shareholders or bankruptcy.

The discipline to increase dividends in good times and improve the balance sheet is a good indicator of management quality. The patience to wait for a downturn to pursue mergers and acquisitions and launch new projects is also a good opportunity to acquire valuable assets cheaply.


Transport bottlenecks can hurt O&G producers’ margins. A good example is Canadian production, which is largely contained and limited by insufficient pipeline capacity. Sometimes this can lead to a $10-$20 discount on international prices and put a limit on potential growth.


The oil and gas industry is a highly cyclical and capital-intensive sector. Therefore, it is important to pay attention to debt & CAPEX, management quality and the economic cycle. Geography/jurisdiction and geopolitical risks should also be on investors’ checklists. The unpredictable nature of exploration for deposits and the possibility of industrial accidents (e.g. the Deep Water Horizon explosion) add to the uncertainty.

As a result of these factors, investors in the sector will benefit from more than usual diversification and should demand a high margin of safety. More suited to a deep value strategy than a buy-and-hold portfolio, the O&G industry can deliver huge returns with an aggressive, well-timed strategy. But it is a risky sector, with very high volatility, and probably only suitable for investors with the right temperament and a disciplined approach to risk.

This post Primer for the oil and gas industry

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